Rabushka on the Flat Tax

Alvin Rabushka of Stanford University's Hoover Institution lays out the case for the flat tax, a reform of the current system that would replace the 66,000 page U.S. tax code with a single rate and no deductions other than personal exemptions. An individual tax return would fit on a simple postcard. Rabushka discusses the economic changes that would come with such a reform and the adoption of the flat tax around the world since Rabushka and Robert Hall proposed the idea in 1981.

Highlights

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0:37

Intro. What are the virtues and vices of a flat tax? Virtues: simplicity instead of long forms, even just a postcard. Complications, deductions, credits cleaned up, one low rate, no double-taxation, no capital gains taxes, no taxes on interest. One rate means people don't shift income between business and personal taxes, doesn't matter how your income is earned. Allows you to do your tax returns in five minutes. No multi-year depreciation. For taxpayers, one low rate provides incentives for work, savings, and investment. For economy, more jobs, higher standard of living. For government, easier system to enforce. Fewer accidental mistakes. Important feature: same rate for individuals and businesses, not different rates. Business owners do not have an incentive to try to move money around wastefully just to avoid taxes. In 1980s, Rabushka talked to 400 financial planners, asking what they do. What they said they do is work to reduce the taxes for their clients. Only 4 said they could still earn a living if there were a flat tax. Most people would not need a financial planner with a flat tax. Those 396 other smart financial planners would do something else, more productive. Less time and money would have to go toward income tax preparation. Avoids system of fearing the IRS. Mayflower Compact. When ship arrived there were no vested interest when they sat down to write a compact. If we started from scratch, we'd agree that a flat tax would be best. The fear is getting into the political game to undo the special interest benefits that have been enacted. Tradeoffs of a reform process are risky.

10:33

Where does the number 19% come from? Originally was a revenue-neutral plan. How much money does the government collect? Continue to give low-income people the same exemption. What percentage would generate the same revenue? Came out to 19% in early 1980s. Today closer to 17%. Rabushka and Hall want to see 20% as a barrier. Currently collect 18.5%, of which 11% is income tax, the other 8.5% is social security payroll tax. Virtually all economists agree there would be a net benefit to economic growth as a result of a flat tax, which over time would result in an increase in revenue or a reduction in the rate. Picture of the postcard is in the book; it isn't tiny print. You don't even need instructions at the personal level. Some instructions necessary for businesses. Schedule D and parts of Schedule B would be gone; no more need to keep track of bank and brokerage statements.

16:11

What about other forms of tax simplification? Consumption tax, sales tax, income tax minus savings. But sticking just with the flat tax, there are some people who don't think it's a good idea. Why? People worry about getting rid of deductions. Mortgage interest deduction would disappear, which alarms people who are used to it. First, Canada, Australia, and New Zealand do not allow mortgage interest deduction and still have same incidence of home ownership. Second, many people do not itemize, largely those with modest incomes. Borrowing example. Perverse situation is that the richer you are, the bigger the benefit. If you lose the deduction when going to the flat tax, it is more than offset by the lower flat tax rate. It's curious that the same people who are disturbed about insufficiently taxing the wealthy are not concerned that the wealthy gain the most from the mortgage interest deduction. Same is true for charitable contributions. Universities, operas, ballets, museums all like this and lobby against removing the deduction. In actuality, when the deduction rates were cut, charitable contributions went up because real incomes went up. Hard to persuade people to focus on the evidence rather than the argument. A little hard to measure, but the evidence is generally on the side that when tax rates are cut, giving goes up. Scare tactics. People worry that their home prices would decline without the demand subsidized by the mortgage interest deduction. But going back to the Mayflower Compact question: Why would we want to subsidize bigger houses (which is what mortgage deduction does)? No externality there, no economic argument for it. Purely a benefit to the construction industry. Bigger houses are nice, but not a goal for social policy. It also subsidizes home owners at the expense of renters. Houses increase in size naturally with wealth; deduction causes a bigger increase than it would be. Used to be able to write off credit card interest; state and local tax deductions are limited by alternative minimum tax. Congress can reduce the deductions for any reason, but typically it's to raise revenue, so it is without giving you lower rates. Nothing sacrosanct.

27:44

Distributional effects. People worry that the flat tax is a benefit for the rich, helps the poor and hurts the rich. Language in the tax debate is confusing. Big difference between tax rates and tax revenue. Lowering your taxes can be used to mean either. Flat tax discussion is a reduction in the tax rate. The marginal rate is 39.6%, but lower incomes are taxed at lower rates. Flat tax would lower the rate, but not necessarily the amounts paid. Fewer loopholes. Progressive taxation versus proportional taxation. Under a pure flat tax, the rich would pay more than the poor. With a progressive tax, they would additionally pay a higher tax rate. "Proportional single rate tax is different from a graduated tax rate schedule." Brackets would rise as income rises. Flat rate tax with a personal exemption of $40,000 is automatically progressive, with an average tax rate that would rise only gradually at the income levels of 90% of the population. But is it progressive enough? Critics say no. History: Under Eisenhower, 11 different tax rates. Kennedy proposed tax rate reduction that involved taking a lot off the top rate. No one accused him of helping his wealthy friends at the time. G. W. Bush raised marginal tax rates on the wealthy. How can you pick a year and say "That's the kind of progressivity we like! That achieves social equity!" Progressivity actually changes every year.

37:43

Corporate income tax versus individual income tax. People confuse the idea that corporations are merely legal entities that collect income on behalf of their owners. Businesses don't pay taxes--people do. Flat tax in fact increases taxes for those whose income depends on businesses. Other benefits outweigh the distributional issues, which are always changing. Rising incomes and more jobs has to help those at the lower income levels. Payroll taxes. Hall and Rabushka decided it was too much to ask Congress to concurrently deal with both payroll and income taxes at the same time, so they focused on the income tax. It is possible to do the two together, with a resulting 25% tax rate instead of the 19% rate. Hard to explain to both reforms at once to political interests. The payroll tax gives the illusion that social security is being funded, but in fact it all goes into the same pot. The payroll tax is also regressive.

45:23

Fringe benefits. When marginal rates are high, there is an incentive to give and take compensation in the form of fringe benefits--payments in kind. $1 in every $3 is now taken as a fringe benefit. But fringe benefits encourage people to do things they wouldn't ordinarily choose. They also hide the economy's performance and the standard of living, making the standard of living look more stagnant than it is. Flat tax proposal as proposed by Rabushka and Hall would reduce those effects by requiring the value of a fringe benefit to count same as cash income for tax purposes. We always look to complicating the tax code as a solution to every problem; but each one further misallocates resources.

49:36

History of the idea behind the 1981 proposal. What was the impact on the United States? Abroad? Initially a big rush of enthusiasm, but faded during recession. Tax reform act. Picked up in 1984; 1986 reduced top marginal tax rate, down to 2 rates. Liked flat tax but couldn't go all the way so "settled on a compromise." But most of the deductions were not removed, most of the complexity stayed! 1990s: Steve Forbes ran on the flat tax. Tax complexity grows. Some temporary reductions in some rates, but lots more credits. Today, flat tax is on the back burner in the U.S. Outside the U.S., lots of success for the flat tax! Break-up of the Soviet Union provided opportunity for major redesign of tax systems: Estonia adopted a flat tax, booming economy, low tax rate, personal allowance but no corporate income tax. Latvia, then Lithuania. Russia tried 3 rates but most people didn't pay. Capital flight, recession. Adopted flat tax, budget is now in surplus. Ukraine, Slovakia, Mongolia, lots more adopting flat tax or considering it. In Estonia it's so easy it's all done online. Some proposals in Italy, Spain; but most of Western Europe is tied into older "social justice" system. Did any countries go from a complex system to a flat tax rather than getting there from scratch? Yes: Russia, Ukraine, Slovakia; Romania, Montenegro, Macedonia, Georgia, Mongolia, Mauritius. Did they throw out their deductions or just simplify rate structure? Most of them didn't have badly complicated deduction schedules to start out with. That may be the road block--more interest groups in established Western nations. Idea is spreading, but to come are breakthroughs in Latin America, Africa, Western Europe; then interest might revive in U.S.

Great podcast, very informative. I'm curious, why tax corporate income and end the tax on corporate income while taxing individual's gains from ownership. I ask because this appears to be easier to tax to me if only because it's easier to quantify (dividends + capital gains). I got this idea from an article by George Stigler who points out in an article on utility regulation that it removes profit from the books, but not stock market performance.

Exactly my point. The tax rate needs to be flat and simple. Anyone with a High School Diploma should be able to fill in his tax forms. That would make things much easier in the economy. But I'm afraid there is lots of vested interest behind the present complicated tax system.

I think the podcast underplayed Rabushka's main point: Ending the delivery of subsidies to favored interests.

What makes the current tax code complicated is all the various flavors of deductions and exemptions. If there were no exemptions, a graduated tax would fit just as easily on a post card. After all, how much space does it take to show three rates instead of one?

Conversely, a flat tax which preserved all the current exemptions would be just as complicated. You'd still have all the forms and schedules to determine taxable income.

Is Rabushka calling for switching from tax cut subsidies to explicit payments from the General Fund? You would still need to determine who qualified for what, and unless you wanted a whole new government bureaucracy the responsibility would fall to individuals. Net effect: People would file a simple tax form and a new, just-as-complicated-as-the-current-tax-form subsidy form.

If Rabushka is calling for ending all such subsidies entirely, that would be revolutionary. The government would no longer favor some interests (like poor people being able to eat) over others(a millionaire drinking a $6 coffee instead of a $5 coffee). You would stop getting exemptions for children and dependents, because that too is a subsidy favoring families over individuals.

Talking about simplifying the tax code obscures the real question- should the government (which it's worth remembering, we elected) be allowed to act through subsidies on its preferences?

One point I did not hear discussed was the ramifications of eliminating the mortgage interest deduction. I wonder what the effect would be on home prices generally since such a deduction is often figured into the price of buying a (often first) home. I agree that the mortgage interest deduction is among the biggest welfare programs going and tends to subsidize sprawl and suburbia--itself a terrible misallocation of resources. But if it were eliminated, the asking price of most homes would decline at least somewhat. Fair enough if it is across the board but I can only imagine the howls and screams from the taxpaying rank-and-file who would see it as diminishing their net worth overnight.

The flat tax idea is certainly a good one, but even if does actually collect more revenue from 'the rich' (mainly by making tax shelters less sweet), it has a major hurdle in being sold to the public. The Schadenfreude factor. It doesn't pay voters to be rational. So they may as well be emotional. And schadenfreude, envy and sheer bloody-mindedness count for more with voters than rational argument.

Your guest talked about the success of the flat tax in Russia and he said
something like "they've put a couple of guys in prison for not paying
taxes so now everyone does". I suspect he meant Mikhail Khodorkovsky and
Platon Lebedev who were indeed put in prison in 2003 with an official
excuse being "taxes". The reality though is that they are still in prison
purely for political reasons and taxes never mattered at all. Moreover,
Mikhail Khodorkovsky was one of the examples of a "tax-paying businessman".

Even more interesting is that he was exactly the man who lobbied the flat
tax reform that Rabushka praised so much. True, some people now credit Mr
Putin for it but the reality was that the reform was conducted despite him
not because of him and the real people behind it are those who were than
put in prison. I realise that it is not an important point for you, but
still it would help if the US flat tax proponents knew their real friends
in Russia.

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